What is Debt Consolidation? A Comprehensive Guide on How to Consolidate Debt

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If you are dealing with multiple debts and a whole lot of money stress, you’ve come to the right place to learn about debt consolidation, also known as debt relief. It’s a process that involves swapping high-interest debt (say, from multiple credit cards that are getting close to being maxed out) for one loan that offers a single lower monthly payment. For many, debt consolidation can be a way to eliminate debt in an affordable and streamlined way. And there’s also the benefit of less money anxiety once the weight of the debt is lifted.

So read on for a guide to debt consolidation. You’ll learn about what it does, its pros and cons, the steps involved, and more. Then you can see whether it’s the right next path for you as you work to pay off your debt.

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Understanding How to Consolidate Debt: What is Debt Consolidation?

A good place to start is with the definition of debt consolidation: It’s a financial strategy that involves combining multiple debts into a single, more manageable monthly payment. Instead of juggling a number of accounts with varying balances, interest rates, and due dates, you wind up with just one check to write (or transfer to make).

It’s not just about simplicity, though. It’s also about affordability. Debt consolidation loans can be drastically less expensive than credit card debt. Currently, the average credit card interest rate is an eye-watering 24.6%; and personal loans are a relatively more manageable 11.6%. This differential can put more cash in your pocket.

The primary goal of debt consolidation is to streamline your finances, reduce monthly payments, and create a realistic way to kick your debt to the curb. Read on for details and tips.

Pros of Debt Consolidation

There are multiple benefits of debt consolidation, as mentioned above. Let’s dig into the specifics.

Simplified finances. By consolidating debts, you reduce the number of monthly payments, making it easier to manage and budget effectively. It also means you will be less likely to miss a payment by accident when you are feeling overwhelmed by bills. You get relief from high payments and the stress of juggling different accounts.

Potential interest savings. Depending on the method chosen, you may secure a lower interest rate, leading to overall savings. Or you might have an extended term that allows for a lower monthly payment (though potentially more interest paid over the life of the loan).

Credit score improvement. Timely and consistent payments on a consolidated debt should have a positive impact on your credit score over time. The largest single contributing factor to your credit score, at 35%, is your payment history, which means how well you pay your bills by their due date.

Cons of Debt Consolidation

Now, the potential downsides of debt consolidation:

Temporary credit score impact. Initially, the act of opening a new credit account or loan may cause a dip in your credit score. That’s because a hard credit inquiry is typically involved. But this is usually a downgrade of maybe five points for just a few months.

Risk of accumulating new debt. If you are struggling financially, there’s still a risk of falling into the trap of accumulating new debt after consolidation. How so? You see those high balances vanish, breathe a sigh of relief, and get tempted to shop again. You may hear this referred to as a “debt trap.” Avoiding this means examining such factors as your income level, your cost of living, and your spending habits. Adopting new and improved money-management routines takes time and discipline (but you can do it!).

Fees. Some consolidation methods, such as debt consolidation loans, may involve fees. It’s crucial to factor these into your decision. For instance, you may have to pay a percentage of the amount you borrow.

“You may have to pay upfront origination fees to take out a new loan, and many credit cards charge balance transfer fees. You’ll want to calculate how much the fee will be and compare it to your potential savings to see if debt consolidation makes financial sense.”

Experian
Types of debt consolidation

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Types of Debt You Can Consolidate

So far, we’ve mentioned high-interest credit card debt as the kind of debt you can consolidate. That’s a major factor for many people’s finances The total credit card debt in America recently topped $1 trillion. But consider this list of types of money owed that you can package up via debt consolidation and pay off:

  • Credit card debt
  • Student loan debt
  • Auto loan debt
  • Medical debt.

Take a look at your finances, and determine exactly how much debt you have, the interest rate on each variety, and which accounts could benefit from consolidation.

Types of Debt Consolidation

Once you’ve established the balances and interest rates, delve into the different debt-consolidation options. Here’s a primer on what may be available:

Debt consolidation loans

This is one of the most commonly used forms of debt consolidation. A debt consolidation loan involves taking out a new loan to pay off existing debts. The borrower then focuses on repaying the single loan, ideally at a lower interest rate than the combined rates of the previous debts.

These loans may also be called personal loans. They are unsecured, meaning you are not borrowing against collateral, such as, say, any home equity you may have. They are typically fixed-rate. Depending on the particular product, the lender may pay your creditors off directly or else send you the funds to do so.

Because you are opening a new line of credit, your credit score is likely to temporarily drop by several points. However, this can be offset by timely payments, which contribute to a score boost.

Balance-transfer credit cards

For those grappling with high-interest credit-card debt, a balance transfer can be an effective strategy. This involves moving the balances from high-interest credit cards to one with a lower (or 0%) introductory interest rate. The introductory period will usually last about 18 months, and the principle at work is that you will use that time to play catch-up and pay down your debt since the lower interest rate frees up cash.

However, as beneficial as this can be, it’s crucial to factor in any balance transfer fees. It’s also important to note that interest rates can skyrocket after an introductory period expires. Or that a high interest rate could apply to new purchases while the existing balance alone enjoys the lower or 0% interest rate. In other words, it’s on you to carefully evaluate offers and read that fine print. Run the numbers and make sure you come out ahead.

Again, you can anticipate a slight credit score decrease of maybe five points for a few months since you are accessing a new line of credit. Paying your debt on time will help compensate for this.

Home equity loans or lines of credit

Homeowners can often leverage the equity in their homes as collateral to consolidate debts. This involves using a home equity loan (aka a second mortgage; a lump sum payment to you of funds to use) or line of credit to pay off high-interest debts (this is similar to credit cards in that you access funds up to your limit as you go). You will need to be able to show steady income and a solid credit score (from 620 to 680) for this option.

“Second mortgages tend to require higher credit, so in order to qualify for a home equity loan, you have to demonstrate that you have the ability to repay the loan. But overall the process for getting a home equity loan is simple.”

Fortune

While this method often offers lower interest rates, it also puts the home at risk if repayments are not maintained. Serious consideration should be given before diving into this option.

And, you guessed it: Whenever you have a hard credit inquiry to get a loan or open a line of credit, your credit score will likely dip for a brief period of, say, a few months. Steady, on-time payments, however, can help build your score over time.

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Debt management plans

Debt management plans (or DMP) are typically offered by credit counseling agencies. They involve the agency negotiating with creditors to lower interest rates and consolidate payments into a single monthly sum. You then pay the agency monthly, and they distribute payments to your creditors. Only unsecured debt is eligible for these plans; that means mortgages and auto loans can’t be part of this kind of plan. In addition, student loans (a form of unsecured debt) may not be wrapped into these plans either.

Do your research carefully on different companies and offers. This is not a free service: On average, you will pay $33 for the plan’s set-up and then $24 a month for the program.

Securing a DMP doesn’t directly impact your credit, though there may be a note in your file that you are using such a plan, according to Experian.

Always make sure to read over any contracts before signing. If a company is pushing you to dive in more quickly than you’d like or says the offer will expire in the very near future, proceed with caution. Such hard-sell tactics are not a good sign.

Selecting the Best Debt Consolidation Method For Your Situation

Choosing a debt consolidation method requires examining your financial situation, goals, and payment preferences. Don’t dive in and accept the first offer. Here are things to consider:

Debt consolidation loans

Good for: Those seeking simplicity and a potentially lower interest rate for various kinds of debt.

Considerations: Assess your credit score and eligibility for favorable loan terms. If you already have past-due bills affecting your credit score, any loan offers may end up with a higher interest rate. This could then wind up costing even more than your current debt burden.

Balance transfer credit cards

Good for: Individuals with high-interest credit card debt.

Considerations: Factor in any fees and the duration of the introductory interest rate. Ensure you can repay the transferred balance within the promotional period to maximize savings.

Also, don’t forget to check the fine print:

“The card issuer is required to tell you how long you will have the introductory rate and what rate applies after the introductory period. If the introductory rate is variable, it can still change during the first six months if the index on which it is based (for example, the prime rate) changes.”

ConsumerFinance.gov

Home equity loans or lines of credit

Good for: Homeowners with significant equity seeking lower interest rates.

Considerations: Understand the risk involved, as your home is used as collateral. Ensure you can easily meet repayment obligations to safeguard your home.

Debt management plans

Good for: Those who prefer professional assistance and structured repayment plans.

Considerations: Research and choose a reputable credit counseling agency. Be committed to adhering to the negotiated payment plan.

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Questions to Ask Yourself About Debt Consolidation

Not sure which option is the right fit for you? Dig in a little deeper.

Personal evaluation

Assess your financial goals: Determine whether your primary goal is to lower interest rates due to the shifting economic climate, find a more affordable payment amount, or have a shorter time until payoff is complete so you can move onto other financial priorities. Or you may be seeking a combination of these factors.

Consider your credit score: Don’t forget that different methods have varying requirements, so evaluate your credit score and eligibility for each option. You can go directly to the credit bureaus or visit AnnualCreditReport.com for a free credit report.  

Evaluate repayment capacity: Analyze your ability to make consistent payments and factor in any financial uncertainties or emergencies that may arise. You don’t want to choose a method that involves a possibly too big payment. In that scenario, missing your major payment could tank your financial progress.

Professional advice

Credit counseling agencies: If considering a debt management plan, consult with credit counseling agencies to understand the services offered and associated costs. But even if you are not sure which path to eliminating debt is best for you, it can be a smart move to talk with a professional. It’s important to find a credit counselor who is willing to go over all the details and share different approaches to help you regain financial stability.

How to Consolidate Debt: A Step-by-Step Guide

Are you ready to get started?

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Step 1. Assess your debts

Begin by compiling a full list of all your debts, including their interest rates, monthly payments, and the date they will be paid off at your current payment rate. This should provide a clear overview of your debt burden.

Step 2: Explore consolidation options

Based on your financial profile, research and understand the various consolidation methods available. Look into the current lenders to find out what they are offering.

Research and compare lenders

Start by researching lenders that offer the type of consolidation methods you are considering. Look for institutions with a track record of transparent practices and reliable customer service.

Compare interest rates and fees

Explore interest rates, fees, and repayment terms offered by the different lenders. A lower interest rate can significantly impact the overall cost of the consolidation, so it’s crucial to find competitive rates even if it means putting some serious time into your search. Be sure to check how rates might balloon over time (as with a balance-transfer credit card).

Consider customer service

Assess the quality of customer service provided by any potential lenders. Look at their customer reviews, and be sure to review the negative comments. Choose a lender that is more likely to be responsive, and address your concerns throughout the application process and beyond. A good loan offer doesn’t mean much if the lender is bad.

Step 3: Choose the right method

Select the consolidation method (or methods) that aligns with your financial goals and capabilities. Whether it’s a debt consolidation loan, balance transfer, or another approach, ensure it fits your unique circumstances first.

Check the eligibility requirements

Each lender may have specific eligibility criteria. Review their requirements to ensure you meet the minimum qualifications before starting the application process. Common factors include credit score, income, and debt-to-income ratio.

According to ConsumerFinance.gov, here is the formula for determining your debt-to-income ratio:

  • Add up all your monthly debt payments and divide them by your gross monthly income.
  • Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
  • Example: If you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2,000 ($1500 + $100 + $400 = $2,000).
  • If your gross monthly income is $6,000, then your debt-to-income ratio is 33 percent. ($2,000 is 33% of $6,000.)

Lenders often look for a DTI of no more than 36%. In some cases, a lender may approve an applicant with up to a 43% DTI.

Also get ready to put together the paperwork you need. Prepare necessary documentation, such as proof of income, employment information, and a list of current debts. Having these ready can make the application process a lot easier.

Step 4: Apply for your chosen consolidation option

After carefully evaluating the various debt consolidation methods and determining the most suitable one for your financial situation, the next step is the application process. Here’s how to get there:

Apply online or in person

Almost all lenders offer online application processes for convenience. Fill out the application form accurately, providing all required information. If you have trouble or have anything you still need to discuss, it may be worth scheduling an appointment for a phone call or in person at a local bank branch instead.

Read everything carefully

Yes, it takes time, but:

Review loan agreements. Before finalizing any agreement, carefully review the terms and conditions of the loan or consolidation plan. Pay attention to interest rates, repayment schedules, any associated fees, and any potential penalties for early repayment or late payments.

Clarify the terms with your potential lender. If there are aspects of the agreement that you find unclear, don’t hesitate to seek clarification from the lender. Understanding the terms is crucial to avoiding surprises later.

Examine interest rate fluctuations. If you’re opting for a variable interest rate, ask about potential fluctuations and how they might impact your monthly payments. You’re probably aware of how much interest rates have shifted over the last few years, so you’ll wan to be prepared.

Monitor the application process

Regularly check your application status: Stay informed about the status of your application by checking with the lender regularly. It is important to be proactive in addressing any additional requests for information or documentation so your application stays on track.

Be prepared for verification: Lenders may conduct verification checks on the information provided. Be prepared to respond promptly to any requests for verification to avoid delays in the approval process.

Step 5: Plan for the repayment of your consolidated debt

Develop a repayment strategy. While awaiting approval, double-check to make sure the payment plan can realistically fit into your budget.

Prepare for adjustments. If your application is approved, be ready to adjust your budget to accommodate any changes in the anticipated repayment terms.

Maintain Financial Discipline After Consolidation

It gets easier, but the work doesn’t stop after consolidation.

Create a budget you can stick to

With the consolidation in place, focus on making timely payments. A crucial aspect of post-consolidation financial health is crafting a budget and sticking to it. Outline your monthly income and necessary expenses, and allocate a portion for savings and debt repayment.

Build an emergency fund

Building an emergency fund is essential for preventing future reliance on credit in case of unexpected expenses, like pricey dental work or car trouble. Aim for at least three to six months’ worth of living expenses in your emergency fund. Yes, that can take time to accumulate. Start small: $20 per paycheck is fine.

Have regular financial check-ups

Make financial check-ups a regular practice (quarterly can be a good cadence). Assess your financial goals, review your budget, and stay vigilant about any changes in your financial situation, like a rent hike. Being proactive can help to address potential challenges before they become significant issues.

Celebrate the milestones

As you progress, take the time to celebrate milestones. Whether it’s paying off a portion of your debt or reaching a certain credit score, acknowledging your achievements can be a great motivator for getting to your final goal of freedom from debt. We don’t mean to fly off to Belize for a week, but some positive and frequent self-talk about your solid work is a good option, or perhaps a celebratory drink with your significant other or BFF.

Explore Alternatives If Debt Consolidation Might Not Be The Right Fit

You’ve just learned a lot about debt consolidation. But it’s not right for everyone, so you may want to consider these options.

Credit counseling

If debt consolidation doesn’t align with your financial goals or if you don’t qualify, credit counseling is often a viable alternative. Non-profit credit counseling agencies can provide personalized advice, assist in creating a budget, and negotiate with creditors on your behalf to establish more manageable repayment plans.

Negotiate with creditors

Take the initiative to communicate with your creditors directly. Express your commitment to repaying the debt and inquire about possible hardship programs or restructuring options. Some creditors may be willing to work with you to find a solution.

Debt settlement

While it comes with its own set of risks, debt settlement involves negotiating with creditors to settle the debt for a lesser amount than what is owed. This can be an option for those facing significant financial hardship, but it’s crucial to understand the potential impact on credit scores and the risks involved. Wondering about those risks? Your creditors don’t need to agree to this kind of plan and could instead take legal action against you.

That said, there may be a positive outcome.

“Offer a one-time payment. A credit card issuer will sometimes accept a lump sum payment of less than the total owed. If you’re a few months behind on your payments and there is a real chance you’ll declare bankruptcy, the issuer may accept a one-time payment, as it can actually save the lender money in the long run.”

Equifax

Bankruptcy consideration

In extreme cases where all other options have been exhausted and financial recovery seems unattainable, exploring bankruptcy may be necessary. Consult with a bankruptcy attorney to understand the implications, eligibility criteria, and the specific type of bankruptcy you will need.

Now you know many of the ins and outs of debt consolidation. Use this knowledge wisely as you decide the best path forward to eliminate your debt.

How to Consolidate Debt: Frequently Asked Questions (FAQs)

Do you still have questions? Check below!

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Will debt consolidation hurt my credit score?

Answer: Initially, there is likely to be a small, temporary dip in your credit score as you access a new line of credit (this is due to a hard credit pull). However, making consistent payments can contribute to an improvement in your score.

Can I consolidate both secured and unsecured debts?

Answer: Yes, some consolidation methods (such as a debt consolidation loan) allow for combining both secured and unsecured debts. However, it’s important to understand the implications, especially when turning unsecured debts into secured ones. There is a risk of losing assets.

Are there risks involved in debt consolidation?

Answer: Yes, like any financial strategy, debt consolidation carries risks. These include potential limitations on future financial options, the need to commit to a long-term plan, fees you may need to pay, and legal issues and loss of assets if you struggle to make the payments.

How long does the debt consolidation process take?

Answer: The timeline varies based on the chosen method and individual circumstances. Debt consolidation loans and balance transfers can be relatively quick, while debt management plans may take longer.

Can I consolidate student loans through debt consolidation?

Answer: Yes, federal student loans can be consolidated through federal programs, and private student loans can be consolidated through private lenders. It’s essential to understand the terms and conditions of student loan consolidation. The Federal Student Aid site can help you to explore options.

What happens if I miss a payment during the debt consolidation process?

Answer: Missing a payment can have adverse effects, including late fees and potential damage to your credit score. It’s crucial to communicate with your lender immediately if you anticipate difficulties in making a payment and explore possible solutions.

Will debt consolidation eliminate my debts entirely?

Answer: Debt consolidation doesn’t erase your debts; it restructures them for more manageable repayment. Successfully completing the consolidation plan will lead to debt reduction, but the complete elimination of debts depends on your financial discipline and if your chosen method covers all your current debt.

Can I continue using credit cards after consolidating my debts?

Answer: Yes, but we don’t recommend it beyond the amount you can pay off in full each month. The use of credit cards often leads to financial pitfalls and more debt.

Is debt consolidation the same as debt settlement?

Answer: No, debt consolidation and debt settlement are distinct strategies. Debt consolidation involves combining multiple debts into a single payment with potentially lower interest rates. Debt settlement focuses on negotiating with creditors to settle for less than the full balance.

Can I change my consolidation method if my financial situation changes?

Answer: Depending on your circumstances, it may be possible to explore alternative consolidation methods or modify existing arrangements. Read any agreements before signing to see if they will block future options.

Can I consolidate medical debts through debt consolidation?

Answer: Yes, medical debts can be included in certain debt consolidation methods.

Your Personalized Debt Consolidation Blueprint

Armed with knowledge on how to consolidate debt, you are now equipped to craft your personalized debt consolidation blueprint.

Remember, the journey to financial freedom is unique for everyone. Make the choices that are best for you.  

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Catherine Marucci
Another Second Opinion
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